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Investment Management Update Investment Management Update Document Transcript

  • Fall 2009 In this issue: Investment The SEC Inspector General’s Report on the SEC’s Failures to Catch Madoff, and the SEC’s Resulting Internal Enforcement Reforms ...................................................... 1 Management Weathering the Storm in a Post-Madoff World .............................................................. 1 XBRL Mandate, EDGAR Updates, and Mutual Fund Risk/Return Rule Offer Innovative Research Tools to Investors .................................................................. 2 Update SEC Enforcement’s New Focus on Asset Management .................................................... 4 Kanjorski Bill to Register Advisers ................................................................................ 6 CFTC and SEC Harmonization .................................................................................. 8 Lawyers to the investment SEC Staff Conditionally Allows Foreign Funds to Invest in U.S. Funds in management industry Excess of Anti-Pyramiding Limitations of 1940 Act ........................................................ 11 Recent IRS Guidance Clarifies Tax Treatment of RIC Investments in Public-Private Investment Program ..................................................... 13 Weathering the Storm in Industry Events ...................................................................................................... 19 a Post-Madoff World The SEC Inspector General’s Report on the SEC’s By Beth R. Kramer and Megan B. Munafo Failures to Catch Madoff, and the SEC’s Resulting From the collapse of Lehman Brothers to Internal Enforcement Reforms the devastating Ponzi scheme perpetrated By Nicholas S. Hodge, Richard A. Kirby and Melissa S. Holmes by Bernard Madoff, the financial services Although reports of Bernie Madoff and his life of luxury and deception have faded from the press, the industry as we knew it has forever changed. SEC has been thrust back into the spotlight with the release on September 2, 2009 of a scathing report Investment advisers are doing their best (the “Report”) that details the agency’s astounding failure to uncover the largest Ponzi scheme in history. to prepare for and adapt to the evolving According to the Report, issued by the SEC’s Inspector General (OIG), three SEC examinations, two nature of the industry and the repetitive SEC investigations, six substantive complaints and two industry articles expressing doubts about Madoff’s warnings issued by regulators. As the claimed returns should have led the SEC to discover the fraud, possibly as early as 1992. The OIG SEC recently alerted advisers during its reported that the SEC’s failure to take action in the face of multiple red flags presented to its staff left 2009 CCOutreach Regional Seminars, even Madoff astonished that he was not caught sooner. it is important for an investment adviser, through its Chief Compliance Officer and With the release of this Report, the SEC Chairman, Mary Schapiro, released a statement detailing Compliance team, to arm itself with the regulatory reforms that the SEC has implemented and/or is seeking to implement by rule and additional knowledge to survive these “unforgiving powers through congressional action to address regulatory gaps. SEC Director of Enforcement Robert times” where an infraction that in the past Khuzami, in congressional testimony, then elaborated on structural and other changes to the Division’s may have resulted in a deficiency letter, operational approach to investigations. The OIG followed with an announcement, on September 29, now, in 2009, may result in an 2009, of another report identifying specific deficiencies in the enforcement program and making 21 enforcement action. specific recommendations, which the Division has undertaken to implement in order to strengthen that program and to avoid a repeat of the mistakes identified by the OIG. Briefly, these reforms focus on The SEC has recently touted its plans to (1) the vetting process for reviewing and evaluating tips and complaints; (2) increased training for the strengthen and enhance its training and enforcement staff; (3) providing adequate qualified staff tailored to the matters at issue in a specific expertise related to adviser examinations. investigation; (4) emphasizing the planning, oversight and management of the investigation process, In preparation for an on-site examination including the process for opening and closing of investigations; and (5) increased cooperation with the in this new regulatory environment, CCOs other SEC operating divisions. continued on page 17 continued on page 15 Fall 2009 1
  • Compliance Corner XBRL Mandate, EDGAR Updates, and Mutual Fund Risk/Return Rule Offer Innovative Research Tools to Investors By Gwendolyn A. Williamson The SEC took further steps to implement its highly publicized eXtensible Business Reporting periods beginning on or after January 1, 2010. The SEC reportedly is working with XBRL U.S., the Language (XBRL) rules, released in final form last January, by releasing updated EDGAR version domestic arm of XBRL International (a consortium (9.16) and related changes to the EDGAR Filer Manual, effective August 4, 2009. These rules of representatives from the global financial represent the latest move in the SEC’s initiative to gradually phase in use of XBRL. In the SEC’s reporting community), “to develop the standard view, once the initiative is complete, shareholders and financial advisors alike will benefit from list of tags for the risk/return summary section of the dynamic research and analysis capabilities created by the integration of XBRL into the SEC’s mutual fund prospectuses and the schedule of corporate disclosure scheme. investments for investment companies.” Among other revisions, including an upgrade publications laying out roadmaps for initiating For companies that are not excluded from to the taxonomy for U.S. generally accepted XBRL compliance and working through the mandatory compliance with the XBRL rules, accounting principles (U.S. GAAP), EDGAR 9.16 updated EDGAR system. Similarly, XBRL solutions, generally including those filing registration reflects “clarifications to the instructions on XBRL/ such as outsourcing, and comprehensive statements under the Securities Act of 1933, interactive data tagging.” The intricacies of the implementation packages are available to financial statements and their footnotes included in final XBRL rules, the updated EDGAR Filer Manual, mandated and to voluntary XBRL filers. quarterly reports filed on or after June 15, 2009 and the February 11, 2009 Interactive Data for must be tagged in XBRL. These companies also Currently, mutual funds and other investment Mutual Fund Risk/Return Summary Rule (Mutual must post interactive financial statements on their companies registered under the 1940 Act are Fund Risk/Return Rule) will likely be clear only website no later than the end of the calendar not required to file using XBRL, nor are business to the technologically savvy reader. The end year the financial statements were filed or were development companies or certain foreign private product of these regulatory developments, required to be filed, whichever is later, and issuers. These companies may file interactive however, has the potential to revolutionize the must keep them posted for a period of twelve financial statement information using XBRL on a way professional and individual investors interact months. XBRL filings will be submitted as exhibits voluntary basis until otherwise notified by the SEC. with the securities markets. to traditional EDGAR filings, which currently Voluntary XBRL filers may begin and cease filing are formatted in American Standard Code for Since the final XBRL rules release, industry in XBRL at their own discretion, but must follow Information Interchange (ASCII) or HyperText service providers—from EDGAR filing support the XBRL rules applicable to mandated filers when Markup Language (HTML). All documents filed to accountants and auditors—have introduced preparing and submitting financial data in XBRL. with the SEC in XBRL are subject to the provisions a variety of aids for SEC filers. For example, Beginning January 1, 2011, under the Mutual of the federal securities laws. webinars describing the principal elements of Fund Risk/Return Rule, registered investment the final XBRL rules and comparing them to the companies will be required to use XBRL to tag the proposed rules are available online, as are risk and return information in their prospectuses for 2 Investment Management Update
  • Application and Import of the to shareholders will contribute to recovery in the markets, given its promoted potential to restore XBRL Initiative. investor confidence through education and greater The final XBRL rules and the Mutual Fund Risk/ transparency; while perhaps overly optimistic, this Return Rule represent the SEC’s stated commitment hope expresses the ambition of the architects of to promoting “efficient and transparent capital XBRL. markets” and its efforts to use “developments in technology and electronic data communication Filers, and their accountants/auditors, will need [to facilitate] greater transparency in the form to be organized in approaching XBRL. Given of easier access to, and analysis of, financial the complexities of the XBRL rules, such as the reporting and disclosures.” First introduced with annually updated XBRL taxonomy and tagging/ a voluntary filer program in 2005, through mapping, linkbase, extension, and instance which the SEC evaluated its pros and cons, document requirements, mutual funds and other XBRL tags and maps a company’s financial data, companies should have a strategy for preparing enabling investors to download a company’s and testing the portions of their SEC filings that financial information “directly into spreadsheets, will be submitted in XBRL. [to] analyze it using commercial off-the-shelf software, or use it within investment models in The final XBRL rules, which detail how to other software formats,” all of which allows for execute and comply with the rules, are the ready “comparison of financial and business available at http://www.sec.gov/rules/ performance across companies, reporting periods, final/2009/33-9002/pdf, and the updated and industries.” XBRL presents “a significant EDGAR Filer Manual is accessible at http:// opportunity to…increase the speed, accuracy, www.sec.gov/info/edgarshtml. The Mutual Fund and usability of financial disclosure.” Over time, Risk/Return Rule and several corrections thereto XBRL, the Mutual Fund Risk/Return Rule, and other are available at http://www.sec.gov/rules/final. technological initiatives – such as the Paperless shtml. Proxy and Summary Prospectus Rules – also promise to reduce costs for shareholders and to mitigate the environmental footprint of mutual funds and other SEC filers. The realization of XBRL by the SEC places the U.S. in step with its international peers. XBRL is currently mandated or used voluntarily in regulatory filing programs throughout Western Europe, as well as Australia, Canada, China, India, Japan, Korea, Singapore, and Thailand. One of the hopes pinned on XBRL is that the information it offers Fall 2009 3 View slide
  • SEC Enforcement’s New Focus on Asset Management By Stephen J. Crimmins Responding to heavy criticism from the Hill and the media, the SEC is in the midst of reinventing The SEC Enforcement Division’s new interest in its enforcement program. Featured prominently in this effort are investment advisers, investment the investment management world comes as the Division is making fundamental changes in its companies, hedge funds and private equity funds. In recent Senate testimony, the SEC’s new organization and procedures, with the overall Enforcement Director Robert Khuzami focused Congress on his concern that asset managers theme of empowering staff to undertake bolder “are responsible for an ever-growing percentage of invested assets, and [that] the lines between initiatives with fewer approvals. Some of the different entities involved in these markets are blurring and overlapping.” more important changes include the following: The most important change in SEC enforcement 1940 Act issues in other parts of the Enforcement • Staff Authorizing Investigations: Previously, for the investment management community will Division, particularly on technical questions such the five SEC commissioners had to vote on a be the SEC’s creation last month of an “Asset as valuation matters. staff recommendation for a so-called “formal Management Unit” in its Division of Enforcement. order” to initiate a “formal” investigation While the new unit will generate its own with subpoena power to compel testimony This will be a specialized unit that will team investigations, it will also coordinate more closely and document production. Now, such attorneys and investigators at headquarters and with its traditional sources for cases – colleagues formal orders will be issued by any senior in SEC offices around the country, and that will doing inspections in the Office of Compliance officer (the top management rank) in the focus exclusively on possible violations involving Inspections and Examinations (OCIE) and experts Enforcement Division and without Commission asset managers. The SEC is presently considering in the Division of Investment Management. The review or authorization. This will speed up candidates to head the new unit, which it has Enforcement Division has worked with OCIE investigations by making it easy for the staff to promised will be operational within the next to set up an internal hotline for its examiners get subpoena power, and likely increase the couple of months. to use if they feel that anyone is attempting number of formal investigations. When formal Historically, enforcement lawyers at the SEC have to intimidate them, a clear “red flag” in the orders were issued by a vote of the five SEC had only passing knowledge of the requirements Enforcement Director’s view. OCIE is enrolling commissioners, companies often felt a need of the Investment Company Act of 1940 and the staff in a certified fraud examiner program, and to make disclosure, and this would sometimes investment management industry. Things will now generally taking a more aggressive stance in its result in press reports that the SEC had be different. The new Asset Management Unit examinations, for example by reaching out to “elevated” an investigation to “formal” status. will build in-house expertise – through training clients and custodians for “third-party verification” and focused experience, as well as by hiring of what firms are saying. specialists from outside. While the new unit will not handle every investment management matter, it will centrally plan and execute the The most important change in SEC bigger investigations and cases in this area, and it will also serve as a resource for enforcement enforcement will be the SEC’s creation last attorneys facing investment management and month of an Asset Management Unit. 4 Investment Management Update View slide
  • With formal orders now being issued on a typically supervised about four junior staff far more casual basis simply by Enforcement members. Branch chiefs, in turn, reported to Division staff members, judgments may differ assistant directors. Under the reorganization, on when disclosure is required. SEC guidance line staff will now report directly to an assistant on this point would be useful. director, though the assistant director will now oversee fewer people. Further to the goal • Tools to Encourage Cooperation: The of speeding investigations, the Enforcement enforcement staff will be able to offer Division has announced that case decisions that new incentives for individuals and entities previously required Deputy Director approval to cooperate with its investigations. In a will now be made by senior officers throughout departure from past practice, staff will now the Division; that defense lawyers can expect provide informal oral “assurances” that a to get fewer meetings with managers on person has “witness” status and that, based cases; and that staff memos to Commissioners on known facts and in some cases a witness recommending enforcement actions will be proffer, the Enforcement Division does not shorter and subject to fewer reviews. intend to recommend enforcement action. While the “witness” versus “target” distinction • Increase in Enforcement Staff: The SEC has has long been a part of criminal practice, “reprogrammed” funds in its current fiscal SEC attorneys previously lacked authority year for a modest increase in enforcement to indicate a person’s status, and this often staff, and it expects to significantly increase inhibited full cooperation. There will also be staff with more generous appropriations (and formal cooperation agreements under which possibly some form of self-funding) in the years the Division will agree to bring a person immediately ahead. This reverses a trend that or entity’s cooperation to the Commission’s saw SEC enforcement staff decline by 10% attention in any subsequent enforcement between 2005 and 2007. recommendation, and in some cases to specify what the Division’s recommendation will be Plainly the SEC Enforcement Division’s as to the cooperator. Finally, taking another heightened interest in investment management page from criminal practice, there will be issues, coupled with the organizational changes deferred prosecution agreements under which designed to empower enforcement staff, the Commission itself will agree not to proceed means that we have entered a period requiring against an individual or entity in return for an increased attention to legal requirements. As agreement to implement specified procedures always, the best first line of defense in dealing and to waive statutes of limitation to assure with stronger enforcement will be recruiting ongoing compliance. and retaining personnel who can competently handle compliance issues, the establishment • Determination of Penalty Amounts: The SEC and maintenance of quality policies and has dropped its so-called “pilot” program procedures tailored to a particular entity’s that required its staff to get pre-clearance business and operations, and a continuing before negotiating penalty amounts to settle message from management that compliance is enforcement actions. Staff will now be able to an organizational priority. set an amount they feel appropriate under the circumstances and then, with the defendant’s agreement, simply present the final settlement Mr. Crimmins spent 14 years with the SEC’s to the Commissioners for implementation. Enforcement Division and, as Deputy Chief • Removal of a Layer of Supervision: The Litigation Counsel, co-managed its civil litigation Enforcement Division is in the process of program. You may reach him at stephen. eliminating its branch chief position. Branch crimmins@klgates.com or 202-778-9440. chiefs were more experienced attorneys who Fall 2009 5
  • Kanjorski Bill to Register Advisers By Stephen J. Crimmins Declaring that “we need to ensure that everyone who swims in our capital markets has an •The SEC would be authorized to conduct annual pool pass,” the Chairman of the House Financial Services Subcommittee on Capital periodic, special and other examinations of private fund advisers. Where the SEC Markets, Representative Paul E. Kanjorski (D-PA), has introduced legislation to require the determined that the materials it obtains were registration of all domestic investment advisers. The legislation, called the Private Fund necessary to assess the systemic risk presented Investment Advisers Registration Act, has the following principal features: by a private fund, the SEC would have to make them available to the Federal Reserve and other • Advisers to hedge funds, private equity firms, • The SEC would be authorized to require regulators with systemic risk responsibilities. and other private pools of capital would have registered advisers to maintain records and The legislation would eliminate the provision to register with the SEC (unless state regulated). make SEC filings concerning “private funds” that in Section 210(c) of the Advisers Act that The legislation would eliminate the exemption the SEC deems appropriate to protect investors prevents the SEC from obtaining, outside of the from registration under Section 203(b)(3) and, in consultation with the Federal Reserve, to enforcement context, the identity, investments, or of the Investment Advisers Act of 1940, as assess the systemic risk these advisers present. affairs of any client of an investment adviser. amended, for advisers with fewer than 15 These records and reports “shall include” the clients. It would also eliminate other exemptions adviser’s amount of assets under management, • The legislation provides that the SEC may for advisers of “private funds,” including from its use of leverage, its counterparty credit risk determine not to disclose certain information it under the exemptions for intrastate advisers and exposures, its trading and investment positions, obtains concerning private funds, but stipulates commodity trading advisers. “Private fund” is and its trading practices. The SEC would be that the SEC may not withhold such information defined in the legislation as a U.S. fund (U.S. allowed to modify reporting requirements based from Congress, from a federal agency or an organized or 10% owned by U.S. persons) with on the particular types or sizes of private funds SRO acting within its scope of responsibility, or no more than 100 investors or an issuer owned advised, e.g.¸ by varying requirements for in response to a federal court order in a case exclusively by qualified persons (referencing hedge funds and for private equity funds. filed by the SEC or the Justice Department. Sections 3(c)(1) and (7) of the Investment The latter provision raises the prospect that • The SEC would have the power to require Company Act of 1940, as amended). However, defendants in SEC civil enforcement cases advisers to provide to investors, prospective advisers would not be required to register if they may be able to obtain court discovery orders investors, counterparties and creditors, such are a “foreign private fund adviser,” defined as for otherwise confidential information, but disclosures concerning their private funds as the having no U.S. place of business, fewer than 15 subject to court-imposed limitations on use of SEC deems appropriate. U.S. clients, and under $25 million in managed such information. assets attributable to U.S. clients. • The legislation allows the SEC to define the term “venture capital fund” and to provide an Advisers to hedge funds, private equity exemption from registration for an adviser to such a fund. However, the SEC would still have firms, and other private pools of capital the power to require such advisers to maintain would have to register with the SEC records and provide reports to the SEC. 6 Investment Management Update
  • The SEC would have the power to require advisers to provide to investors, prospective investors, counterparties and creditors, such disclosures concerning their private funds as the SEC deems appropriate. At the same time, Chairman Kanjorski introduced “comprehensive study of the entire securities two related pieces of legislation. The first, the industry by a high caliber body” to identify and Investor Protection Act, would double the SEC’s implement further reforms. budget over five years and give the SEC new The other legislation proposed by Chairman enforcement powers. The Act would also subject Kanjorski, the Federal Insurance Office Act, broker-dealers to the same fiduciary duty to their would develop expertise at the federal level customers as investment advisers, create an concerning insurance products, assess and expanded whistleblower bounty program, allow mitigate systemic risks from such products, and the SEC to forbid mandatory arbitration clauses, coordinate with foreign insurance regulators. and authorize the PCAOB to examine auditors The new Federal Insurance Office would be part of broker-dealers even if they are not public of the Treasury Department. companies. It would also direct a Practice Highlight Registered Investment Companies Practice For several decades, the K&L Gates Investment Management practice has been ranked in the top tier of investment management practices, providing premier legal counsel to the investment company industry. We have over 100 lawyers practicing in 14 offices across three continents who provide services to the registered fund industry. We represent clients in connection with the full range of investment company industry products and activities, including all types of open-end and closed-end investment companies, exchange-traded funds, funds-of-funds, funds-of-hedge funds, variable insurance products, and unit investment trusts. Our clients run from start-up managers and specialized firms to some of the largest fund managers in the world. As the industry has developed, grown and innovated, our lawyers have been at the forefront of those developments. From creation and registration with the SEC, to distribution, day-to-day compliance, sale, merger and consolidation of funds, K&L Gates is well-versed in all legal issues relating to registered funds, as well as all aspects of operations. Fall 2009 7
  • CFTC and SEC Harmonization By Molly Moynihan On October 16, 2009, the SEC and the CFTC released the Joint Report of the SEC and the Uniform Fiduciary Standard CFTC on Harmonization of Regulation. The Report contains 20 recommendations, including The Report recommends legislation to impose proposals to: a uniform fiduciary duty on intermediaries who provide similar investment advisory services • impose a uniform fiduciary duty on dual registrants; and (viii) cross-border regulatory regarding futures or securities. The agencies intermediaries who provide similar services for matters. The second section provides 20 specific recommend that a consistent standard apply to futures or securities, recommendations, divided into four categories: any commodity trading advisor (CTA), futures Markets, Financial Intermediaries, Enforcement and commission merchant (FCM), introducing broker • grant the SEC specific statutory authority for Operational Coordination. The recommendations (IB), broker-dealer, or investment adviser who aiding and abetting under the Securities Act and include 12 recommendations that would require provides similar investment advisory services. The the Investment Company Act, legislative action and 8 actions that the agencies recommendation is consistent with other legislative could take themselves. efforts to establish a uniform standard of conduct • enhance customer protection and the authority to deal with insider and disruptive trading, for broker-dealers and investment advisers, In preparation for the Report, the two agencies including Title IX of the Administration’s financial • address portfolio margin accounts, and conducted extensive inter-agency discussions and held their first ever joint meeting on September regulatory reform legislation. • expedite judicial review of jurisdictional disputes. 2-3, 2009 to address harmonization of regulation. While the Report contains a number of concrete Aiding and Abetting In addition, the Report recommends creation of The CFTC already has specific statutory proposals, most of these will require new a Joint Advisory Committee and a Joint Agency enforcement authority for aiding and abetting any legislation, and other important issues were left on Enforcement Task Force, and contains various violation of the Commodity Exchange Act (CEA) the table, suggesting that true harmonization is still proposals for sharing and joint training of staff. or CFTC rules or regulations. The Report proposes very much a work in progress. legislation to grant the SEC specific statutory The Report is broken down into two main sections. This article briefly summarizes the recommendations authority for aiding and abetting under the The first is a lengthy review of CFTC and SEC and related areas of concern identified in the Report. Securities Act and the Investment Company Act, regulatory approaches, focusing on eight areas which would make those statutes consistent with of concern: (i) product listing and approval; the Securities Exchange Act and the Investment (ii) exchange/clearinghouse rule changes; (iii) Advisers Act. risk-based portfolio margining and bankruptcy/ insolvency regimes; (iv) linked national market and common clearing contrasted with separate markets and exchange-directed clearing; (v) The Report contains a raft of proposals to market manipulation and insider trading; (vi) enhance cooperation and coordination customer protection standards applicable to financial advisers; (vii) regulatory compliance by between the two agencies. 8 Investment Management Update
  • Market Manipulation and basis of material non-public information from any The Report recommends legislation that would governmental authority, for example, misuse of provide a process for expedited judicial review Disruptive Trading material non-public information from the Treasury of jurisdictional matters regarding new products. Both the CEA and the Securities Exchange Act Department, the Department of Agriculture and the Specifically, the legislation would establish and prohibit market manipulation. However, the Federal Reserve. clarify: (i) legal certainty with respect to the different nature of the securities and futures markets agencies’ authority over products exempted by the and their regulatory regimes has resulted in two Portfolio Margining other agency; and (ii) a review process to ensure very different approaches to the issue. In cases A major area of concern identified during the that any jurisdictional dispute is resolved by the involving securities, manipulation usually involves public hearings relates to portfolio margining. agencies against a firm time line. Notably, the false statements or a “pump and dump” scheme Currently, futures positions may not be included in two agencies did not propose that another to manipulate price for trading advantage. a securities customer portfolio margining account. financial regulator, such as the Treasury, Commodities cases, on the other hand, typically Many market participants have argued that the adjudicate such disputes. involve the use of market power to force the short CFTC and SEC should resolve the issue of whether side of a transaction to deal with the long side on and how futures should be included in a portfolio A central source of competitive inequality terms created by the long side. margin account, and generally permit customers between the two regulatory regimes is thought to to margin all related instruments in one account. arise from the fundamentally different operating Because of the different nature of the markets, It is thought that the ability to margin all related principles guiding the SEC and CFTC. The different approaches may be inevitable. However, instruments in one account would allow customers CFTC has operated under a “principles-based” the Report notes that certain practices are so to better manage risk and capital efficiencies regulatory approach for the exchanges and disruptive to trading in the futures market that they across their entire portfolio. clearing organizations under its jurisdiction. should be presumptively prohibited. Accordingly, The governing statute of the CFTC, the CEA, the Report recommends legislation to enhance In response, the Report recommends legislation sets forth separate sets of “core principles” for the CFTC’s enforcement authorities with respect to to facilitate the holding of (i) futures products in exchanges and clearing organizations. While disruptive practices that undermine market integrity an SRO securities portfolio margin account and all futures exchanges and clearing organizations and the price formation process in the futures (ii) securities options, securities futures products, must adhere to the core principles applicable markets, although these “disruptive practices” are and certain other securities derivatives in a to them, they are given considerable discretion not specified. futures portfolio margin account. The Report also in determining how they will do so. In addition, suggests that the two agencies review their existing the CFTC sets regulatory objectives for regulated Insider Trading customer protection, margin and any other relevant entities. SROs may establish or change their own The securities laws contain strong prohibitions regulations to determine whether any rule changes rules by certifying to the CFTC that the new rule against corporate insider trading on the basis of or exemptive relief would be necessary to achieve complies with the CEA. In contrast, where the SEC material, non-public information, which do not the full benefits of risk-based portfolio margining. is involved, SROs are subject to a “rules-based” have a counterpart under the CEA. The CEA regulatory approach, under which each new or only prohibits insider trading on single stock Finally, the Report suggests that the agencies amended SRO rule must be approved by the SEC. futures, primarily because the concept of an explore, with input from experts, the industry, “insider” (with its attendant fiduciary obligations) and the public, whether further modifications The Report recommends legislation to enhance is not typically applicable to futures instruments, to portfolio margining, including adoption of a CFTC authority over exchange and clearinghouse such as commodities, and because it is expected one-account model that would accommodate all compliance with the CEA, asserting that the that end users will hedge in the futures markets financial instruments and all broker-dealers and CFTC currently lacks sufficient authority to ensure on the basis of information known only to the FCMs, would be in the public interest. that exchanges and clearinghouses it regulates user. However, the commodities laws do contain are operating within the principles, rules and prohibitions against misusing information, for Rule Changes and Introduction regulations established under the CEA, are able example by entering into proprietary trades based to adapt to market conditions and international on information about a customer’s order. of New Products standards, and protect the public. The Report Currently, if a financial product has attributes of recommends that the CEA be amended to provide both securities and commodities, introduction In an incremental approach to expanding insider the CFTC with clear authority with respect to of the product can face significant delays trading prohibitions under the CEA, the Report exchange and clearinghouse rules that the CFTC while regulators determine whether the product recommends legislation to amend the CEA to make determines are necessary to comply with the CEA. should be regulated by the SEC or the CFTC. unlawful the misappropriation and trading on the Fall 2009 9
  • Investor Protection Issues Third, the Report recommends that the CFTC and • A Joint Advisory Committee to identify emerging The Report contains recommendations linked to the SEC review regulatory requirements applicable regulatory risks and assess and quantify their investor protection covering conflicts of interest, to investment advisers and CTAs/commodity pool implications for investors and other market restitution and whistleblower protections. The operators (CPOs) with respect to private funds participants, and provide recommendations for Report recommends legislation to authorize the to eliminate, as appropriate, any inconsistent solutions. CFTC to require FCMs and IBs to implement or conflicting provisions regarding: (i) the use • A Joint Agency Enforcement Task Force conflict of interest procedures that would separate of performance track records; (ii) requirements to harness synergies from shared market the activities of persons in a firm engaged in applicable to investor reports (including the surveillance data, improve market oversight, research or analysis of commodity prices from financial statements often used by registered enhance enforcement, relieve duplicative those involved in trading or clearing activities. investment advisers to comply with the Investment regulatory burdens, and oversee temporary Advisers Act custody rule and the financial details of personnel. The CFTC currently has express authority to seek statements delivered to investors by CPOs); and • A joint cross-agency training program for staff restitution for investor losses in administrative (iii) recordkeeping requirements. that would focus on enforcement matters. proceedings. The Report recommends legislation to • A program for the regular sharing of staff clarify that restitution in CFTC enforcement actions Cross-Border Issues through detailed assignments. is defined in terms of the losses sustained by The Report recommends that the SEC review its • A Joint Information Technology Task Force to persons as a result of the unlawful conduct. approach to cross-border access to determine pursue linking publicly filed information on whether greater efficiencies could be achieved CFTC and SEC regulated persons to create a The recommendations do not deal directly with the with respect to cross-border transactions in comprehensive, consolidated database. key concerns of differing treatment of segregation securities which would be consistent with the of assets and insolvency. protection of investors and the public interest. Overall, the Report represents a serious effort to meet the challenges posed by harmonization. Recordkeeping and The Report also recommends legislation to Chairman Gensler has repeatedly expressed empower the CFTC to require any foreign board his commitment to the process and the need to Disclosure Issues of trade that seeks to provide direct access to lower risk throughout the system and increase The Report contains three recommendations transparency. Chairman Schapiro has been members or other participants located in the aimed at harmonizing recordkeeping and somewhat more muted than Chairman Gensler, United States to register with the CFTC. When disclosure requirements. perhaps because the SEC is the dominant appropriate, the Report suggests relying on the applicable foreign regulator to avoid duplicative regulator. Now that the agencies have spoken, First, it recommends that the SEC and the continued progress towards harmonization will regulation. CFTC undertake to align their record retention require both coordinated rule-making by the two requirements for intermediaries by harmonizing Coordination between agencies as well as legislative changes that the length of time records are required to be will require cooperation between the two major maintained. The Report envisages that the general the Two Agencies committees in Congress that govern securities CFTC record retention standard of five years may Finally, the Report contains a raft of proposals to and commodities. be adopted by both agencies. enhance cooperation and coordination between the two agencies. These include: Second, the Report recommends that the agencies undertake to provide greater consistency in their customer risk disclosure documents. Specifically, the SEC indicated that it may consider amending the requirements for the Options Disclosure Document (ODD). One panelist complained that the ODD can The Report contains recommendations linked to exceed 100 pages, and should be more like the investor protection covering conflicts of interest, restitution and whistleblower protections. futures disclosure of two or three pages. 10 Investment Management Update
  • SEC Staff Conditionally Allows Foreign Funds to Invest in U.S. Funds in Excess of Anti-Pyramiding Limitations of 1940 Act By Gwendolyn A. Williamson The SEC staff has broken new ground by allowing foreign investment companies (Foreign The SEC staff’s assurance of no action under the Funds) to buy up to three percent of the voting securities of domestic registered investment facts and representations presented in the Foreign Fund request letter also was based on adherence companies (U.S. Funds) without complying with the anti-pyramiding limitations of Section 12(d) to the following conditions: (1)(A)(ii) and (iii) of the 1940 Act. In a recent no-action letter, the staff determined that the restrictions of Section 12(d)(1)(A)(ii) and (iii)—which generally prevent an investment company • Compliance with the restrictions of Section 12(d) from investing more than five percent of its total assets in any one investment company and from (1)(A)(i) of the 1940 Act. Foreign Funds may investing more than ten percent of its total assets in investment companies in the aggregate – not purchase more than three percent of a U.S. would not apply to Foreign Funds under certain circumstances. The no-action request was made Fund’s outstanding voting securities. on behalf of U.S. Funds seeking to provide investors of Foreign Funds access to a diversified • Agreement to not offer or sell securities in the fund portfolio by supplementing or replacing direct investments in U.S. securities markets. The U.S. or to any U.S. Person. In order to rely request letter is available on the SEC’s website, www.sec.gov, under the Division of Investment on the no-action letter, an acquiring Foreign Management’s link to its staff no-action and interpretive letters. Fund could not offer or sell its securities to U.S. Persons as defined in Rule 902(k) of Regulation Considering the legislative history of Section 12(d) laws for the protection of foreign investors in these S under the Securities Act of 1933. This group (1), the SEC staff wrote that Congress aimed to circumstances. While noting that Section 12(d)(1) generally includes individuals residing in the curtail, among other practices, “pyramiding of reflects Congressional concern that shareholders U.S., partnerships and corporations organized voting control in the hands of persons that owned could be negatively affected by duplicative fees in the U.S., trusts and estates administered by only a nominal stake in an acquired company… and unnecessarily complex investment strategies U.S. Persons, agencies and branches of foreign and the ability of the acquiring company to and/or portfolio composition, the staff response governments located in the U.S., accounts exercise undue influence over the adviser of the seemed to recognize that Congress had little held for the benefit of a U.S. Person or by acquired company through the threat of large- regulatory interest in protecting Foreign Funds and a fiduciary residing in the U.S., and foreign scale redemptions and the concomitant loss of their shareholders from such abuses. partnerships and corporations formed by a U.S. advisory fees.” The SEC staff reasoned that as Person for the purpose of investing in securities long as a Foreign Fund limits its holdings to no not registered under the Securities Act, unless more than three percent of the voting securities of organized by accredited investors who are not a U.S. Fund, as required by Section 12(d)(1)(A)(i), individuals, trusts, or estates. removing the five and ten percent limitations of Section 12(d)(1)(A)(ii) and (iii) would not subject The no-action relief provided by the SEC U.S. shareholders to the risks envisioned by Congress. staff has the potential to attract foreign The SEC staff also seemed to be persuaded that there is no need to apply the federal securities investors to U.S. Funds. Fall 2009 11
  • The SEC staff also seemed to be persuaded that there is no need to apply the federal securities laws for the protection of foreign investors in these circumstances. • Commitment to transacting offshore. Each Implications for U.S. Funds. The no-action relief transaction made in reliance on the no-action provided by the SEC staff has the potential to letter must be consistent with the definition of attract foreign investors to U.S. Funds. Especially “offshore transactions” set forth in Rule 902(h) in light of the economic turmoil of the last year, this of Regulation S: an offer or sale of securities should come as good news for funds interested occurs offshore if (1) the offer is not made to a in securing new foreign investments or increasing person in the U.S., and (2) either (A) the buyer the investments of existing foreign investors. It is not in the U.S. when the purchase order is also creates new opportunities for Foreign Funds, placed, or the seller reasonably believes the expanding their ability to invest in the U.S. mutual buyer is outside the U.S. at that time, or (B) the fund market. transaction is carried out through an established Any U.S. Fund issuing shares to a Foreign Fund foreign exchange located outside the U.S. or in reliance on the no-action letter should consider through a designated offshore securities market, whether its compliance program under Rule and the seller does not know that the transaction 38a-1 requires modification to ensure compliance has been prearranged with a U.S. buyer. with the conditions imposed by the SEC staff. In • Compliance with the restrictions of Section 12(d) addition, a U.S. Fund’s board and management (1)(B) of the 1940 Act. Each U.S. Fund involved would be wise to keep an eye to the possibility in a transaction relying on the no-action letter that funds and shareholders could be impacted, in must adhere to the requirements of Section 12(d) ways both previously addressed and unforeseen, (1)(B), which generally prohibits any registered by the augmented ability of Foreign Funds to open-end investment company, its principal acquire U.S. Fund shares. underwriter, and any registered broker/dealer from knowingly selling securities if the sale would cause more than three percent of its outstanding voting securities to be acquired or more than ten percent of its securities to be owned by other investment companies in the aggregate. 12 Investment Management Update
  • Tax Update Recent IRS Guidance Clarifies Tax Treatment of RIC Investments in Public-Private Investment Program By Thomas F. Joyce and Roger S. Wise The IRS has recently issued two pieces of guidance clarifying the tax treatment of investments by regulated investment companies (“RICs”) in public-private investment partnerships (“PPIPs”). Background on PPIPs “look through” a partnership in which it invests the partnership’s income, gain, loss, deduction The public-private investment program is one of the for purposes of satisfying the income test. Thus, if and credit be proportionate to its ownership initiatives implemented by the Treasury Department a RIC invests in a partnership, the RIC may treat interest therein. However, Revenue Procedure as part of its Financial Stability Plan in connection the items of income included in its allocable share 2009-42 imposes no such restrictions on the with the Emergency Economic Stabilization Act of of partnership’s income as “good” income under partnership allocations, and one can surmise that 2008 (the “EESA”). Under the Legacy Securities these tests to the extent that those items would have it was issued, in part, to allow the “look through” Program (initiated under authority of the EESA), the so qualified if the RIC had earned that income approach described above despite the fact that Treasury Department will invest in PPIPs—generally directly. However, there is no explicit statutory the RIC invests in a PPIP that provides for special in the form of debt and equity—alongside private support for asset diversification “look through.” allocations to certain partners. (The capital investors. These partnerships will purchase “Legacy Revenue Procedure 2009-42, 2009-40 I.R.B. structure and operating rules of a PPIP may make Securities,” which are certain eligible commercial 459, issued on September 9, 2009, permits a special allocations unavoidable, and any special mortgage-backed securities and certain eligible RIC to “look through” to the underlying assets of allocation must be agreed to by the Treasury non-agency residential mortgage-backed securities a PPIP in which it invests for purposes of satisfying Department in its capacity as an investor.) Thus, issued prior to 2009 that were originally rated the quarterly asset diversification tests set forth in while the Revenue Procedure’s conclusion is an AAA. The rationale for the program is that these section 851(b)(3) of the Code. important, and likely justifiable, departure from securities, though trading at reduced prices, could historical agency practice in light of the current Earlier guidance issued by the IRS had generally ultimately perform. extraordinary economic circumstances, it probably permitted RICs that invest in partnerships to rely on should not be read as relaxing or liberalizing the Each PPIP is generally structured in the same a similar “look through” approach for purposes of theoretical underpinnings that informed the IRS’s manner, with Treasury investing directly, and the quarterly asset diversification tests. However, traditional, conservative position on this question. private investors investing through one or more that guidance imposed a number of conditions, Investors in partnerships outside the PPIP context or feeder funds. Some of these feeder funds are RICs. including, among other items, a requirement PPIP investors that do not fit the mold of Revenue that the RIC’s allocable share of each item of Income and Assets Tests A fund must satisfy an annual income test and quarterly asset diversification tests in order to The rationale for the program is that these qualify for treatment as a RIC under the Internal Revenue Code of 1986, as amended (“Code”). securities, though trading at reduced prices, The Code already makes clear that a RIC may could ultimately perform. Fall 2009 13
  • Procedure 2009-42—to fit within the scope of the Revenue Procedure 2009-38, 2009-37 I.R.B. Revenue Procedure, a RIC must invest at least 70% 362, issued on August 27, 2009, provides that of its original assets (including seed capital and a PPIP will not be treated as a TMP so long as it net proceeds from an initial public offering) as a holds Legacy Securities and the U.S. Government partner in one or more PPIPs—the limitations of the owns a “significant equity interest” in the fund. IRS’s historical guidance on these issues will need Although significant equity interest is not defined, it to be kept in mind. seems reasonable to presume that the 50% equity interest that is typical for PPIPs would suffice. This guidance also applies to other entities (i.e., feeder Taxable Mortgage Pools funds), and portions thereof, that invest substantially A real estate mortgage investment conduit all of their assets in a qualifying PPIP. (“REMIC”) is a special vehicle under the Code for the issuance of mortgage-backed securities. Revenue Procedure 2009-38 is somewhat unusual To ensure that multi-tranche offerings of mortgage- in that it is more of a “no-action” letter than a backed securities are done only through REMICs, statement of the IRS’s interpretation of the law. In the Code provides that an entity, or a portion of the Revenue Procedure, the IRS merely states that an entity, that primarily holds mortgages secured it will not assert that a PPIP or related entity is by real property and issues debt with more than a TMP. one maturity tied to those mortgages (a “taxable mortgage pool” or “TMP”) will be treated as a corporation if it does not elect REMIC status. That is, the TMP rules essentially force securitization vehicles to elect REMIC status by subjecting them the Revenue Procedure’s conclusion... to a corporate-level tax if they do not. A PPIP could meet the definition of a TMP because it will hold mortgages secured by real property. probably should not be read as relaxing or The PPIP will issue one tranche of debt to the liberalizing the theoretical underpinnings Treasury Department under the public-private investment program, and may issue additional that informed the IRS’s traditional, tranches of debt–perhaps also to the Treasury conservative position Department under other programs established pursuant to the stimulus bill. Treating such a PPIP as a TMP–taxable as a corporation–would defeat (or impede) the purpose of the program. 14 Investment Management Update
  • continued from page 1 The Report also noted a number of ways in which The SEC Inspector General’s Report on the SEC’s the failure to catch Madoff was influenced by Failures to Catch Madoff, and the SEC’s Resulting human bias, including Madoff’s stature within the investment community. Madoff determined Internal Enforcement Reforms which of his employees were interviewed by SEC examiners, pushed the examiners to finish their investigation, and intimidated junior examiners Litany of SEC Failures of Madoff’s business, Madoff’s strategy, basic by name-dropping higher-ups at the SEC. Though According to the Report, the SEC failed to custody issues, or equity and options trading. they caught Madoff lying, SEC examiners simply investigate credible complaints adequately, did not Examiners from the SEC’s Office of Compliance accepted Madoff’s answers to their questions, sufficiently prepare for examinations, conducted Inspections and Examinations (“OCIE”) testified including his assertion that he did not take a examinations that were too narrow in scope, that many of them were not familiar with securities performance fee from his funds because he was and staffed examinations with inexperienced or laws, that they had no training, and that they “not greedy.” Personal feelings also played a inappropriate personnel. SEC staff also did not focused on front-running because that was role - because a branch chief personally disliked follow up on contradictory statements made by their area of expertise. Accordingly, the Report Harry Markopolos, an independent financial Madoff, did not obtain third-party verification concluded that, although Madoff provided evasive fraud analyst and a persistent and compelling of Madoff’s trading, and did not understand and inconsistent answers during questioning, the complainant, he “declined to even pick up the Madoff’s strategy or operations. The Report also SEC staff did not appreciate that he never gave a ‘several inch thick file folder’ on Madoff that faults bureaucratic hurdles and lack of information logical explanation for his inflated claimed returns Markopolos offered” and ignored Markopolos’ sharing between SEC offices and divisions. and accepted his claim that they were due to his offers of additional evidence. “gut feel” for the market. More particularly, “perhaps the most egregious failure” of the SEC’s investigations, according to the OIG, was the failure to obtain third-party verification of Madoff’s trading. The Report noted SEC examiners declined to seek trade data that the SEC failed to follow up on reports that from the NASD or audit trail data because it were inconsistent with Madoff’s claims. More than once, a financial institution that Madoff claimed would have taken “a ton of time” to review. to use for trading responded that Madoff had conducted no transactions for the relevant time period, but the SEC did nothing in response. Over the years, the SEC staff drafted several requests The Report identifies a series of problems with The Report also concluded that the SEC staff failed for information from third parties that were never bureaucracy and administration at the SEC. to appreciate the significance of numerous red sent; SEC examiners accepted copies of third-party Despite the seriousness of complaints, the SEC flags, including Madoff’s extreme secrecy, unusual records from Madoff himself; and SEC examiners was slow in responding, delaying nine months fee structure, and consistent, nonvolatile returns declined to seek trade data from the NASD or from the receipt of one complaint before initiating despite his unremarkable trading strategy. Madoff’s audit trail data because it would have taken “a an inquiry. Because one complainant stated returns did not correlate to the overall equity ton of time” to review. Even Madoff thought the that he had withdrawn his money from Madoff, markets in over ten years, his strategy was not jig was up when the SEC asked for his Depository no review or analysis of the complaint was duplicable by anyone else, and the staff ignored Trust Company account number in 2006; to his deemed necessary. Although questions were still evidence that his auditor was a related party. The surprise, the SEC never contacted DTC to verify unanswered following an SEC examination of volume of options Madoff was trading was not his trading. Madoff in 2004, the examiners responsible for visible in the marketplace, and it was impossible that examination were shifted to different projects. for Madoff to have found a counterparty to handle The Report also faults the staffing and scope of There was so little sharing of information between the volume of his ostensible options trading, but the SEC inquiries. The SEC staff was so focused on SEC offices that examiners from one SEC office SEC staff was not sophisticated enough to detect front-running, investment adviser registration and learned from Madoff himself that a parallel “for this and ignored repeated complaints and tips the adequacy of disclosures, according to the cause” examination was being conducted by urging the SEC to focus on these issues. Finally, Report, that they were oblivious to the fraud in front another office of the SEC. Madoff’s incomplete or contradictory responses to of them. Examination teams were inexperienced SEC inquiries and behavior during investigations and simply did not comprehend the fundamentals Fall 2009 15
  • should have caused the SEC staff to push harder; Enforcement Response and developing coordination among SEC offices. instead, it simply backed off. The Enforcement Division is creating five Accordingly, the SEC is seeking more funding specialized units: (1) Asset Management, which from Congress, as the number of entities subject The Chairman’s Statement will focus on investment advisers, hedge funds, to its oversight and examination has grown The day the Report was released, Chairman and private equity funds (see SEC Enforcement’s much faster than the number of staff available to Schapiro released a statement detailing the New Focus on Asset Management, also in examine them. measures the SEC had already taken in the this newsletter); (2) Market Abuse, focusing on aftermath of the Madoff catastrophe. Chairman large-scale abuses and manipulation schemes; The OIG Reform Schapiro noted that the SEC has proposed new (3) Structured and New Products, specializing in Recommendations rules to safeguard investors’ assets and to require complex derivatives and financial products; (4) The implementation of the recommendations of the surprise audits and has pushed for legislation Foreign Corrupt Practices Act; and (5) Municipal OIG will augment the structural reforms identified to compensate whistleblowers. Additional Securities and Public Pension, aimed at abuses by the SEC Enforcement Director. A major focus changes were further detailed in the testimony such as pay-to-play schemes. In addition, an of these reforms is the process by which the of Robert Khuzami before the Senate a week Office of Market Intelligence will be created SEC will review and vet tips, complaints and later, such as improving the handling of tips, within the Enforcement Division to improve the referrals. The new Office of Market Intelligence putting experienced people on the ground, hiring handling of tips and complaints. will coordinate this process. Enhanced training for people with certain skills, increasing training, and law enforcement staff is being given a renewed requesting more resources. OCIE Response priority. Another focus of the reforms is the method OCIE is now emphasizing fraud detection in by which the SEC Enforcement Division staffs, The SEC Response addition to identifying violations of securities laws. plans and supervises investigations. A much more The SEC Director of Enforcement testified before It hopes to fill new “Senior Specialized Examiner” rigorous and systematized process of planning the U.S. Senate Committee on Banking, Housing positions with professionals having experience review and oversight is to be undertaken to keep and Urban Affairs on September 10, 2009 in areas such as valuation, sales and forensic investigations on task and staffed with adequate with a number of responses to the Report. At the accounting. Going forward, OCIE will primarily expertise to address the issues uncovered. administrative and structural level, the SEC plans conduct risk-targeted “sweep” examinations Likewise, the SEC is implementing a more rigorous to reduce management by 40% so that more staffed with multi-disciplinary teams, including process for review of the opening and closing of senior-level employees can participate hands-on teams comprised of both broker-dealer and investigations. in investigations. A chief operating officer will investment management staff for examinations of transfer administrative and infrastructure tasks to entities that engage in both functions. operations personnel and away from investigative personnel. The SEC is also conducting internal Finally, the SEC is augmenting its staff, seeking reviews with the goal of eliminating bureaucratic personnel with practical trading and market skills and training existing personnel in forensic processes and maximizing resources. technology, investigating financial fraud, market manipulation, Ponzi schemes and offering frauds, 16 Investment Management Update
  • continued from page 1 Safeguarding Client Funds Weathering the Storm in a and Securities Post-Madoff World Although custody has been a focus area of the SEC for some time, the Madoff fraud re- emphasized the importance of safeguarding must identify and assess the risk of their firms and may also consider assessing whether accurate client assets. At a minimum, CCOs should confirm evaluate their policies and procedures in order and complete disclosures were made regarding, that the adviser has: (i) policies and procedures to mitigate specific risks associated with their among other areas: (i) conflicts of interest created created to safeguard clients’ funds and securities advisory business. Despite the SEC’s current focus by business arrangements or affiliations; (ii) and protocols for dealing with a third-party on “cause” examinations of investment advisers, compensation arrangements with solicitors and custodian; and (ii) security measures designed firms should be vigilant and prepared for “routine” service providers; (iii) fees paid by clients to the to protect confidential personal information and examinations to continue. Historically, SEC exams firm and affiliates and the services provided; and to prevent unauthorized use of such information. have primarily focused on the effectiveness of (iv) use of client commissions to pay for products In an effort to independently verify investor adviser compliance programs. Now, five years and services. It is also important for CCOs to assets, SEC examiners may contact other service after the adoption of the Compliance Rule, the confirm that all disclosure documents are delivered providers and counterparties and are likely to SEC, expecting a “fully-operational, effective, to clients and filings are made with the SEC in a contact clients directly to confirm consistency compliant compliance program” and is both timely manner. of capital account balances. Because SEC making significant changes to investment adviser examiners are likely to perform certain custodial examinations and turning its attention to other Outsourcing Services checks during an examination, the CCO should areas in an effort to enhance investor protection. Investment advisers may engage third-party consider taking similar steps to confirm that service providers to perform various services advisory clients’ assets are safe, including: (i) As part of the 2009 CCOutreach Regional for their clients. Pursuant to its fiduciary duty to obtaining statements from the custodian; (ii) Seminars, the SEC staff cautioned investment investors, an adviser must supervise its service comparing custodial statements with advisory advisers that the following areas, among others, providers, including sub-advisers, administrators, records; (iii) reviewing its reconciliation process; will likely be the focus of on-site examinations: proxy voting agents, and transfer agents. At least (iv) taking additional steps to confirm assets when • portfolio management; annually, the CCO must confirm that the policies custody is with the adviser or an affiliate; and (v) • outsourcing services; and procedures of each service provider are reviewing account statements sent by the adviser. • safeguarding client funds and securities; adequate in relation to the services performed As the SEC has emphasized, the CCO should be • performance claims; and for its advisory clients, including any mutual fund aware that conflicts of interest and/or potential • valuation. it may advise. As a general matter, this oversight “red flags” may exist in circumstances where the requires initial and on-going due diligence by adviser and the qualified custodian are affiliated, Portfolio Management the CCO and compliance team (e.g., on-site the adviser is in a difficult financial situation, client visits). Where possible, the CCO should perform Although a broad range of advisory activities funds are held at a foreign financial institution, forensic back-testing as a check on the service will continue to be reviewed, the following advisers charge performance fees or the adviser provider, particularly an affiliated entity (e.g., areas will be of specific importance to the SEC hires an inexperienced auditor to perform audits affiliated sub-adviser). During its annual review, staff during examinations: (i) the allocation or surprise verifications. In light of the massive the CCO should assess whether the adviser is of investment opportunities among clients; (ii) Ponzi schemes that emerged over the last year, properly disclosing its use of third-party service consistent adherence to client objectives and SEC examiners will likely assess whether there providers, including whether it uses affiliated restrictions; (iii) appropriate, “meaningful” client are adequate controls in place to prevent the service providers, and applicable fees charged disclosure regarding adviser practices; (iv) the falsification of account statements to clients. for such services. consistency of business operations with regulatory requirements; and (v) the adviser’s code of ethics. In connection with its annual internal review, a CCO should randomly sample client contracts to Despite the SEC’s current focus on “cause” test whether the adviser is adhering to specific examinations of investment advisers, firms client prohibitions (e.g., prohibition on purchasing “sin” stocks) and has adequate policies, should be vigilant and prepared for procedures and controls in place designed to “routine” examinations to continue. comply with specific client guidelines. The CCO Fall 2009 17
  • Performance Claims confirm that advisers have taken reasonable steps Under the Investment Advisers Act of 1940, to determine market valuation where there are as amended, an adviser is prohibited from pricing inaccuracies that come to the adviser’s employing or engaging in fraudulent, deceptive attention. The SEC recommends forensic testing to or manipulative activities, including through the analyze whether the adviser’s valuation policies use of its advertising and marketing materials. and procedures are adequate. In light of current An adviser should make performance claims in market volatility and liquidity issues, as part of marketing materials subject to the verification of the annual review the CCO should review its computation of returns, criteria for including/ current procedures and consider: (i) evaluating excluding accounts, proper maintenance of and verifying the accuracy of prices; (ii) reviewing required books and records, and process for exception reports; (iii) conducting internal audits ensuring clear, accurate disclosure. During its and reviewing related reports; (iv) completing self- annual review, the CCO should review its policies assessments; and (v) documenting and maintaining and procedures and confirm that the adviser’s all quotes received from third-party sources. performance claims are accurate and consistent Despite the state of the economy, investment and that proper disclosures are included. CCOs advisers must remain focused on compliance should periodically test disclosures between and investor protection. In fact, the SEC staff has various types of adviser advertising, including the emphasized how critical the roles of the CCO firm’s website, pitch books and other advertising and compliance personnel are in creating a materials. If GIPS-compliance is asserted, the “culture of compliance” and cautioned advisers CCO must confirm that the firm’s composite against making resource reductions to compliance performance claims are consistent with GIPS programs that could undercut their effectiveness. standards. In addition, it is important for CCOs With the number of enforcement actions on to periodically random sample recordkeeping the rise and the SEC’s active role as “investor practices to confirm that all documents necessary advocate,” it is in the adviser’s best interest to to substantiate advertised performance are maintain a vigilant CCO and compliance team. maintained in the appropriate manner. As 2009 comes to a close, and in anticipation of next year’s annual internal review, the CCO Valuation should thoroughly review its compliance program, Advisers should have adequate policies and mapping the firm’s potential compliance risks in procedures, internal controls and verification light of the past year’s events and any changes processes in place to detect situations where to its advisory business. As part of its review, market values materially deviate from values the CCO should pay particular attention to used to price client portfolios. Because of the information contained in past deficiency letters potential conflict of interest in valuing a client’s and responses, current regional SEC request portfolio, investment advisers must be cautious letters, and the SEC exam focus areas discussed not to overvalue client portfolios thereby creating above. If these steps are taken, the CCO higher advisory fees and performance fees that will be in a better position to demonstrate the are paid to the adviser. Examiners will seek to dynamic nature of its compliance program and its preparation to weather any storm that 2010 has in store for the financial industry. 18 Investment Management Update
  • Industry Events Please visit www.klgates.com for more information on Robert J. Zutz: Judicial and Regulatory Developments, Please join us for our Seminar: the following upcoming investment management events Independent Directors Council, November 17, 2009, Fort in which K&L Gates attorneys will be participating: The Current and Future State of the Hedge Fund Worth, TX Industry: Business Perspectives Stephen J. Crimmins: Understanding the New SEC Robert A. Wittie: Securities Lending, Mutual Fund Directors Thursday, October 29, 2009, 4:00 p.m. to 7:00 p.m. Enforcement Program, Financial Research Associates, Forum and KPMG, November 18, 2009, Webinar (Eastern time) This program will be live in our New York October 20, 2009, Webinar office. David Dickstein: Investment Adviser Association Elaine A. Lindenmayer and Mark D. Perlow: Regulatory Compliance Workshop, December 1, 2009, Los Angeles, This seminar will be conducted as an active dialogue Development Impacting Hedge Fund and the Investment CA among industry speakers, who will respond to ques- Management Industry, 100 Women in Hedge Funds, tions from members of K&L Gates’ New York Investment Kay Gordon and Philip Morgan: Renewable Energy Management group concerning business, legislative and October 28, 2009, San Francisco, CA Funds – New Frontiers for the Funds Industry, Celesq®, regulatory challenges hedge funds may be expected to Michael S. Caccese: Understanding Disclosure: Form December 3, 2009, Webinar face in 2010 and thereafter. Featured industry panelists ADV, Performance and Advertising, NRS, November 4, will be Charles Clarvit (BlackRock Alternative Advisors), Diane E. Ambler: Mutual Funds Under New 2009, Las Vegas, NV Jaeson Dubrovay (NEPC) and David Harmston (Albourne Administration: Litigation and Regulation, Boston University Michael S. Caccese: Investment Adviser Advertising and School of Law, December 4, 2009, Boston, MA America). Marketing; Crisis Management and Internal Investigations, Paulita Pike and Paul Dykstra: Mutual Fund Directors NRS 24th Annual Fall Investment Adviser and Broker-Dealer Please join us for our Seminar Institute, Mutual Fund Directors Forum, January 26-28, Compliance Conference, November 5 and 6, 2009, Las More Enforcers at Your Door: preparing for and 2010, Coral Gables, FL Vegas, NV Responding to Increased Government Investiga- Alan P. Goldberg: Risk Management for Mid-Size Firms, tions and Actions Daniel F. C. Crowley: The Obama Administration’s Impact Investment Adviser Association/ACA Insight 2010 Tuesday, November 17, 2009, 1:45 to 6:15 p.m.This on Private Equity, CLE International Private Equity and Investment Adviser Compliance Forum, February 25, program will be live in our London office. Mezzanine Finance Conference, November 6, 2009, 2010, Arlington, VA Charlotte, NC K&L Gates, in partnership with the Risk Advisory Group, AlixPartners and ELD International, is pleased to invite you Paulita Pike: Director Oversight of Compliance and Risk to this half-day conference on new trends in government Management, Investment Company Directors Conference, enforcement. Hear first hand from current and former Independent Directors Council, November 11-13, 2009, regulators including Richard Alderman, Director, Serious Amelia Island, FL Fraud Office, U.K. and Richard Thornburgh, former U.S. Attorney General and K&L Gates Of Counsel in our Washington, D.C. office. Obtain practical guidance from senior corporate counsel on dealing effectively with multiple regulators and participate in a hands-on workshop Please join us for our 2009 Investment Management Training Seminars led by corporate counsel, consultants and practitioners to At these seminars, lawyers from our Investment Management practice will discuss a broad range of learn how your company can limit exposure to government enforcement action. topics and practical issues. Each program will feature a “Hot Topics” panel discussing current issues con- fronting the investment management industry To register for this event, please go to Live at K&L Gates in Washington, DC and video www.klgates.com/events. Wednesday and Thursday, conferenced to K&L Gates Charlotte, K&L Gates Dallas, November 4 and 5 K&L Gates Miami; K&L Gates Newark, K&L Gates New York and K&L Gates Pittsburgh Tuesday, November 10 Live at the Palace Hotel San Francisco Live at K&L Gates in Los Angeles and video conferenced to Tuesday, November 17 our offices in Orange County, San Diego, and Seattle Thursday, November 19 Live at K&L Gates in Chicago Friday, November 20 Live at K&L Gates in Boston Tuesday, December 8 Live at K&L Gates in New York To register for these seminars, please go to www.klgates.com/events. Fall 2009 19
  • To learn more about our Investment Management practice, we invite you to contact one of the lawyers listed below, or visit www.klgates.com. Austin San Francisco Robert H. McCarthy, Jr. 512.482.6836 robert.mccarthy@klgates.com Kurt J. Decko 415.249.1053 kurt.decko@klgates.com Elaine A. Lindenmayer 415.249.1042 elaine.lindenmayer@klgates.com Boston J. Matthew Mangan 415.249.1046 matt.mangan@klgates.com Joel D. Almquist 617.261.3104 joel.almquist@klgates.com David Mishel 415.249.1015 david.mishel@klgates.com Michael S. Caccese 617.261.3133 michael.caccese@klgates.com Mark D. Perlow 415.249.1070 mark.perlow@klgates.com Mark J. Duggan 617.261.3156 mark.duggan@klgates.com Richard M. Phillips 415.249.1010 richard.phillips@klgates.com Mark P. Goshko 617.261.3163 mark.goshko@klgates.com Thomas A. Hickey III 617.261.3208 thomas.hickey@klgates.com Seattle Nicholas S. Hodge 617.261.3210 nicholas.hodge@klgates.com James A. Andrus 206.370.8329 james.andrus@klgates.com Peter N. McIsaac 617.261.3225 peter.mcissac@klgates.com Clair E. Pagnano 617.261.3246 clair.pagnano@klgates.com Taipei Christina C. Y. Yang +886.2.2175.6797 christina.yang@klgates.com Gordon F. Peery 617.261.3269 gordon.peery@klgates.com Rebecca O’Brien Radford 617.261.3244 rebecca.radford@klgates.com Washington, D.C. George Zornada 617.261.3231 george.zornada@klgates.com Clifford J. Alexander 202.778.9068 clifford.alexander@klgates.com Diane E. Ambler 202.778.9886 diane.ambler@klgates.com Chicago Mark C. Amorosi 202.778.9351 mark.amorosi@klgates.com Cameron S. Avery 312.807.4302 cameron.avery@klgates.com Catherine S. Bardsley 202.778.9289 catherine.bardsley@klgates.com Paul H. Dykstra 312.781.6029 paul.dykstra@klgates.com Ndenisarya M. Bregasi 202.778.9021 ndenisarya.bregasi@klgates.com David P. Glatz 312.807.4295 david.glatz@klgates.com Beth Clark 202.778.9432 beth.clark@klgates.com Alan P. Goldberg 312.807.4227 alan.goldberg@klgates.com Daniel F. C. Crowley 202.778.9447 dan.crowley@klgates.com Thomas F. Joyce 312.807.4323 thomas.joyce@klgates.com Arthur C. Delibert 202.778.9042 arthur.delibert@klgates.com D. Mark McMillan 312.807.4383 mark.mcmillan@klgates.com Stacy L. Fuller 202.778.9475 stacy.fuller@klgates.com Anna Paglia 312.781.7163 anna.paglia@klgates.com Jennifer R. Gonzalez 202.778.9286 jennifer.gonzalez@klgates.com Paulita A. Pike 312.781.6027 paulita.pike@klgates.com Robert C. Hacker 202.778.9016 robert.hacker@klgates.com David C. Sienko 312.807.4382 david.sienko@klgates.com Kathy Kresch Ingber 202.778.9015 kathy.ingber@klgates.com Donald S. Weiss 312.807.4303 donald.weiss@klgates.com Rebecca H. Laird 202.778.9038 rebecca.laird@klgates.com Fort Worth Deborah A. Linn 202.778.9874 deborah.linn@klgates.com Scott R. Bernhart 817.347.5277 scott.bernhart@klgates.com Cary J. Meer 202.778.9107 cary.meer@klgates.com Marc Mehrespand 202.778.9191 marc.mehrespand@klgates.com Hong Kong R. Charles Miller 202.778.9372 chuck.miller@klgates.com Navin K. Aggarwal +852.2230.3515 navin.aggarwal@klgates.com Dean E. Miller 202.778.9371 dean.miller@klgates.com London R. Darrell Mounts 202.778.9298 darrell.mounts@klgates.com Danny A. Brower +44.20.7360.8120 danny.brower@klgates.com Molly Moynihan 202.778.9058 molly.moynihan@klgates.com Philip J. Morgan +44.20.7360.8123 philip.morgan@klgates.com Lawrence B. Patent 202.778.9219 lawrence.patent@klgates.com C. Dirk Peterson 202.778.9324 dirk.peterson@klgates.com Los Angeles David Pickle 202.778.9887 david.pickle@klgates.com William P. Wade 310.552.5071 william.wade@klgates.com Alan C. Porter 202.778.9186 alan.porter@klgates.com Theodore L. Press 202.778.9025 ted.press@klgates.com New York Eric S. Purple 202.778.9220 eric.purple@klgates.com David Dickstein 212.536.3978 david.dickstein@klgates.com Francine J. Rosenberger 202.778.9187 francine.rosenberger@klgates.com Edward G. Eisert 212.536.3905 edward.eisert@klgates.com Bruce A. Rosenblum 202.778.9239 bruce.rosenblum@klgates.com Kay A. Gordon 212.536.4038 kay.gordon@klgates.com Robert H. Rosenblum 202.778.9464 robert.rosenblum@klgates.com Alan M. Hoffman 212.536.4841 alan.hoffman@klgates.com William A. Schmidt 202.778.9373 william.schmidt@klgates.com Beth R. Kramer 212.536.4024 beth.kramer@klgates.com Lori L. Schneider 202.778.9305 lori.schneider@klgates.com Raleigh Lynn A. Schweinfurth 202.778.9876 lynn.schweinfurth@klgates.com F. Daniel Bell III 919.743.7335 dan.bell@klgates.com Donald W. Smith 202.778.9079 donald.smith@klgates.com Andras P. Teleki 202.778.9477 andras.teleki@klgates.com Stacy H. Winick 202.778.9252 stacy.winick@klgates.com Roger S. Wise 202.778.9023 roger.wise@klgates.com Robert A. Wittie 202.778.9066 robert.wittie@klgates.com Robert J. Zutz 202.778.9059 robert.zutz@klgates.com Anchorage Austin Beijing Berlin Boston Charlotte Chicago Dallas Dubai Fort Worth Frankfurt Harrisburg Hong Kong London Los Angeles Miami Newark New York Orange County Palo Alto Paris Pittsburgh Portland Raleigh Research Triangle Park San Diego San Francisco Seattle Shanghai Singapore Spokane/Coeur d’Alene Taipei Washington, D.C. K&L Gates is a global law firm with lawyers in 33 offices located in North America, Europe, Asia and the Middle East, and represents numerous GLOBAL 500, FORTUNE 100, and FTSE 100 corporations, in addition to growth and middle market companies, entrepreneurs, capital market participants and public sector entities. For more information, visit www.klgates.com. K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the United States, in Berlin and Frankfurt, Germany, in Beijing (K&L Gates LLP Beijing Representative Office), in Dubai, U.A.E., in Shanghai (K&L Gates LLP Shanghai Representative Office), and in Singapore; a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining offices in London and Paris; a Taiwan general partnership (K&L Gates) maintaining an office in Taipei; and a Hong Kong general partnership (K&L Gates, Solicitors) maintaining an office in Hong Kong. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. ©2009 K&L Gates LLP. All Rights Reserved.